ECON-UA 2 Textbook Notes

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New York University
Maharukh Bhiladwalla

Microeconomics: Hall and Lieberman What is Economics?  Economics is the study of choice under conditions of scarcity. Scarcity and Individual Choice  Scarcity- a situation in which the amount of something available is insufficient to satisfy the desire for it.  As individuals, we face scarcity of time and spending power. Given more of either, we could each have more of the goods and services that we desire.  Because of the scarcities of time and spending power, each of us is forced to make choices.  Economists study the choices that we make as individuals along with their consequences. When some of the consequences are harmful, economists study what-if anything-the government can or should do about them.  The Concept of Opportunity Cost o The opportunity cost of any choice is what we must forgo when we make that choice. It is the most accurate and complete concept of cost. o When the alternatives to a choice are mutually exclusive, only the next best choice-the one that would actually be chosen-is used to determine the opportunity cost of the choice. o An Example: The Opportunity Cost of College  Explicit cost- the dollars sacrificed-and actually paid out-for a choice. This is part of opportunity cost.  Implicit cost- the value of something sacrificed when no direct payment is made.  The opportunity cost of a choice includes both explicit and implicit costs. o A Brief Digression: Is College the Right Choice?  Attending college appears to be one of the best financial investments you can make. o Time is Money  The explicit (direct money) cost of a choice may only be a part-and sometimes a small part-of the opportunity cost of a choice. Scarcity and Social Choice  Scarcity of resources is what is holding us back from accomplishing the goals of society that would satisfy everyone. In society’s case, the problem is a scarcity of resources. Resources- the labor; capital, land (including natural resources), and entrepreneurship that are used to produce goods and services. The Four Resources  Labor: The time human beings spend producing goods and services.  Capital: A long-lasting tool that is used to produce other goods.  Physical Capital- the part of the capital stock consisting of physical goods, such as machinery, equipment, and factories.  Human capital- The skills and training of the labor force.  If something is used up quickly in the production process it is generally not considered capital.  Capital stock- The total amount of capital in a nation that is productively useful at a particular point in time.  Land- The physical space on which production takes place, as well as the natural resources that come with it.  Entrepreneurship- The ability and willingness to combine the other resources into a productive enterprise.  Anything produced in the economy comes, ultimately, from some combination of the four resources.  Resources v. Inputs o An input is anything used to make a good or service. Inputs include not only resources but many other things made from them (cement, rolled steel, electricity), which are, in turn, used to produce goods and services. o Resources, by contrast, are the special inputs that fall into the four categories. They are the ultimate source of everything that is produced.  Opportunity Cost and Society’s Tradeoffs o Virtually all production carries an opportunity cost: To produce more of one thing, society must shift resources away from producing something else. o For a society opportunity cost arises from the scarcity of resources whereas for an individual it arises from the scarcity of time or money. The World of Economies  Microeconomics and Macroeconomics o Microeconomics: derived from the Greek word “mikros” meaning small. It is the study of the behavior of individual households, firms, and governments; the choices they make; and their interaction in specific markets. o Macroeconomics: derived from the Greek word “makros” meaning large- takes an overall look at the economy. It focuses on the big picture and ignores the fine details.  Positive and Normative Economics o Positive economics deals with how the economy works plain and simple. o Normative economics is the practice of recommending policies to solve economic problems. It goes beyond the facts and tells us what we should do about them. o Every normative analysis is based on an underlying positive analysis. o A normative analysis is always based, at least in part, on the values of the person conducting it. o Why Economists Disagree about Policy  Policy differences among economists arise from (1) positive disagreements (about what the outcome of different policies will be), or (2) differences in values (how those outcomes are evaluated). Why Study Economics?  To Understand the World Better  To achieve social change  To help prepare for other careers  To become an economist The Methods of Economics  Economics has a heavy reliance on models.  A model is an abstract representation of reality.  A model represents the real world by abstracting or taking from the real world that which will help us understand it.  The Art of Building Economic Models o A model should be as simple as possible to accomplish its purpose. It should contain only necessary details. o The level of detail that is perfect for one purpose will usually be too much or too little for another. Example: Maps  Assumptions and Conclusions o Every economic model makes simplifying and critical assumptions. o A simplifying assumption is any assumption that makes a model simpler without affecting any of its important conclusions. o A critical assumption is any assumption that affects the conclusions of a model in an important way. See Appendix Chapter Two: Scarcity, Choice, and Economic Systems Society’s Production Choices  The opportunity cost of having more of one good is measured in the units of the other good that must be sacrificed. The Production Possibilities Frontier  Production Possibilities Frontier (PPF)- A curve showing all combinations of two goods that can be produced with the resources and the technology currently available.  Points outside the frontier are unattainable with the technology and resources at the economy’s disposal. Society’s choices are limited to points on or inside the PPF.  Increasing Opportunity Cost o According to the law of increasing opportunity cost, the more of something we produce, the greater the opportunity cost of producing even more of it.. o It is this law that causes the PPF to have a concave (upside-down) bowl shape.  The Reason for Increasing Opportunity Cost o Because most resources are better suited to some purposes than to others. As we shift more and more resources towards the production of a second good at first the resources that were more suited would be moved but as production of the second good increases more resources that are more apt to the first one get moved to the second. The Search for a Free Lunch A meal is not really free because society still uses up resources to provide it. Society pays an opportunity cost by not producing other things with those resources.  Operating Inside the PPF o When an economy is not living up to its productive potential. o Productive Inefficiency  Resources are not being used in the most productive way.  Productively Inefficient- a situation in which more of at least one good can be produced without sacrificing the production of any other good.  Productive efficiency means the absence of any productive inefficiency. No firm is ever 100% productively efficient.  Business firms have strong incentives to identify and eliminate productive inefficiency, since any waste of resources increases their costs and decreases their profits.  Some inefficiencies aren’t fixed (like federal tax returns) because of lobbying and that it will hurt some people who resist changes in the status quo. o Recessions  A recession is another reason an economy may operate within it’s PPF.  During a recession many resources are idle. An end to a recession would move an economy from a point within it’s PPF to a point on it, as it would use idle resources to produce more goods and services without sacrificing anything.  False benefits from employment: Example how spam has put software engineers to work during a recession, however, these engineers would have jobs in more vital areas if there was no recession so when the recession ends, employment in the spam-fighting industry is the opportunity cost of spam.  Economic Growth o One way productivity capacity grows is by an increase in available resources. The resource that has contributed the most is capital. o The other major source of economic growth is technological change-the discovery of new ways to produce more from a given quantity of resources. o A technological change or an increase in resources, even when the direct impact is to increase production of just one type of good, allows us to choose greater production of all types of goods. o Consumption vs. Growth  Capital plays two roles in the economy. It is a resource that we use to produce goods and services and is a also a good itself and is produced using resources.  Each year we must choose how much of our available resources to use to produce capital, which is a long lasting tool but its production leads to less consumption goods being made.  In order to produce more goods and services in the future, we must shift resources towards Research and Development and capital production, and away from producing things we’d enjoy right now. Economic Systems The way our economy is organized  Specialization and Exchange o Every economic system has been characterized by two features: Specialization, which is a method of production in which each person concentrates on a limited number of activities, and exchange, in which most of what we desire is obtained by trading with others rather than producing for ourselves. o Specialization and exchange enable us to enjoy greater production and higher living standards than would otherwise be possible. As a result, all economies exhibit high degrees of specialization and exchange. o Where do gains from specialization and exchange come from?  Development of expertise- by limiting ourselves to a narrow set of tasks, we can hone our skills and become experts of one or two things rather than amateurs at a lot of things.  Minimizing downtime- there is less unproductive downtime that would result from switching activities, as people spend their time doing one kind of task.  Comparative advantage- allocating resources according to their suitability for different types of production, leads us to get further gains from specialization. Comparative Advantage  Absolute Advantage: A Detour o An individual has an absolute advantage in the production of some good when he or she can produce it using fewer resources than the other individual can. o the absolute advantage is an unreliable guide for allocating tasks to different workers.  Comparative Advantage o The ability to produce a good or service at a lower opportunity cost than other producers.  Gains from Comparative Advantage o When each castaway moves toward producing more of the good in which he or she has comparative advantage, total production rises. o In the end specializing, according to comparative advantage and exchanging with each other gives the castaways a higher standard of living than they could each achieve on their own.  Beyond the Island o Total production of every good or service will be greatest when individuals specialize according to their comparative advantage. This is another reason why specialization and exchange lead to higher living standards than does self-sufficiency.  International Comparative Advantage o A nation has comparative advantage in producing a good if it can produce it at a lower opportunity cost than some other nation. o Examples in book: Chinese and American Soybean and t-shirt production.  Global gains from comparative advantage o Total production of every good or service is greatest when nations shift production toward their comparative advantage goods, and trade with each other. Resource Allocation Societies are confronted with three important questions.  Which goods and services should be produced with society’s resources? o Where on it’s PPF should the economy operate?  How should they be produced? o Most goods and services can be produced in a variety of ways, with each method using more of some resources and less of others.  Who should get them? o Determining who get’s the economy’s output is always the most controversial aspect of resource allocation. Over the last half- century, our society has become more sensitized to the way goods and services are distributed, and we increasingly ask whether distribution is fair.  The Three Methods of Resource Allocation o Traditional Economy- An economy in which resources are allocated according to long-lived practices from the past.  Remains strong in many tribal societies and small villages in parts of Africa, South America, Asia, and the Pacific.  Serious drawback of this economy is that they don’t grow. With everyone locked into traditional patterns of production, there is little room for innovation or technological change.  Traditional economies are likely to be stagnant economies. o Command or Centrally Planned Economies- An economic system in which resources are allocated according to explicit instructions from a central authority.  They are disappearing fast, the only two that are left today are Cuba and North Korea. o Market Economy- An economic system in which resources are allocated through individual decision making.  In a market economy, freedom of choice is constrained by the resources one controls  In a market system, those who control more resources will have more choices available to them than those who control fewer resources. Nonetheless, given these different starting points, individual choice plays the major role in allocating resources in a market economy.  Resources can be allocated through markets and prices.  The Nature of Markets o A market is a collection of buyers and sellers who have the potential to trade with one another. o The market can be global, which is when buyers and sellers are spread across the globe. In other cases the market is local. o Markets play a major role in allocating resources by forcing individual decision-makers to consider their decisions about buying and selling. They do so because of an important feature of every market: the price at which a good is bought and sold.  The Importance of Prices o A price is the amount of money that a buyer must pay to a seller for a good or service. o Price is not always the same as cost. o Prices are so important to the working of the economy because they confront individual decision makers with the costs of their choices.  A Thought Experiment: Free Cars o We’d end up paying for the cars in the end as much of our available labor, capital, land and entrepreneurial talent would be put towards cars rather than education, medical care and perhaps food. o When resources are allocated by the market, and people must pay for their purchases, they are forced to consider the opportunity cost to society of their individual actions. In this way, markets are able to create a sustainable allocation of resources.  Resource Allocation in the United States o U.S. always considered the leading example of a market economy. o Even in the US there are numerous cases of resource allocation outside the market. Many economic decisions are made within families, which do not operate like little market economies. o In the broader economy, there are many examples of resource allocation by command. Various levels of government collect, in total, about one-third of our income as taxes. o In this way the government plays a major role in allocating resources-especially in determining which goods are produced and who gets them. o Also, regulations designed to protect the environment, maintain safe workplaces, and ensure the safety of our food supply are just a few examples of government imposed constraints on our individual choice. o The complete label for the United States is market capitalism. While the market describes how resources are allocated, capitalism refers to one way resources are owned. o Under capitalism, most resources are owned by private citizens, who are mostly free to sell or rent them to others as they wish. o On the other hand, socialism is a type of economic system in which most resources are owned by the state.  Understanding the Market o The market is simultaneously the most simple and the most complex way to allocate resources. o For individual buyers and sellers, the market is simple. There are no traditions or commands to be memorized and obeyed. Instead, we enter the markets we wish to trade in, and we respond to prices there as we wish to, unconcerned about the overall process of resource allocation. o From the economist’s point of view the market is quite complex. Resources are allocated indirectly, as a byproduct of individual decision making, rather than through easily identified traditions or commands. As a result, it often takes some skillful economic detective work to determine just how individuals are behaving and how resources are being allocated as a consequence. Using the Theory: Are We Saving Lives Efficiently See appendix Chapter Three: Supply and Demand Supply and Demand is an economic model, designed to explain how prices are determined in certain types of markets. Markets A market is a group of buyers and sellers with the potential to trade with each other. Economists think of the economy as a collection of markets. Characterizing a Market The first step in analyzing a market is to determine which market we are analyzing.  Broad vs. Narrow Definition o Aggregation- the process of combining distinct things into a single whole. o In economics, markets can be defined broadly or narrowly, depending on our purpose. o In macroeconomics, goods and services are aggregated to the highest levels, in microeconomics markets are defined more narrowly. o There is some aggregation in microeconomics but not as much as in macroeconomics. o While a macroeconomist may ask how much we spend on consumer goods, while a microeconomist may ask how much we might spend on health care or video games.  Product and Resource Markets o Circular flow- a simple model that shows how goods, resources, and dollar payments flow between households and firms. o The upper half of the circular flow model illustrates the product markets which are markets where firms sell goods and services to households. o *In the real world, businesses also sell products to the government and to other businesses, but this simple version leaves out these details. o The lower half of the circular flow model depicts resource markets where labor, land and capital are bought and sold. In this market, households that own resources sell them to firms.  Competition in Markets o A final issue in defining a market is how prices are determined. o In some markets, individual buyers or sellers have an important influence over the price. o Imperfectly competitive markets- a market in which a single buyer or seller has the power to influence the price of a product. o Perfectly competitive markets or competitive markets- a market in which no buyer or seller has the power to influence the price. o In perfectly competitive markets, there are many buyers and sellers, each is a small part of the market, and the product is standardized like wheat. o Imperfectly competitive markets, by contrast, have just a few large buyers or sellers, or else the product of each seller is unique in some way. o The supply and demand model is designed to show how prices are determined in perfectly competitive markets.  Competition in the Real World o Truly perfectly competitive markets are rare. o For example, in the market for laptops there is no single market price that all producers take as given, the market is not strictly perfectly competitive. But laptops made by different firms, while not identical, are not that different. o While few markets are strictly competitive, most markets have enough competition for supply and demand to explain broad movements in price. Demand The quantity demanded of a good or service is the number of units that all buyers in a market would choose to buy over a given time period, given the constraints they face.  Quantity Demanded Implies a Choice o It tells us how much households would choose to buy when they take into account the opportunity cost of their decisions.  Quantity Demanded is Hypothetical o Quantity demanded makes no assumptions about the availability of a good.  Quantity Demanded Depends on Price The Law of Demand states that when the price of a good rises and everything else remains the same, the quantity of the good demanded will fall.  The law of demand tells us what will happen if all the other influence’s on buyers’ choices remain unchanged and only one influence-the price of the good-changed.  “ceteris paribus”- Latin for “all else remaining the same” The Demand Schedule and the Demand Curve  Demand schedule: A list showing the quantities of a good that consumers would choose to purchase at different prices, with all other variables held constant.  The demand curve shows the relationship between the price of a good and the quantity demanded in the market, holding constant all other variables that influence demand. Each point on the curve shows the total quantity that buyers would choose to buy at a specific price.  Virtually all demand curves shift downwards.  Shifts versus Movements Along the Demand Curve o A change in the price of a good causes a movement along the demand curve. o A change in any variable that affects demand-except for the good’s price-causes the demand curve to shift. o If buyers would want to buy a greater quantity at any price the demand curve shifts rightward. If they would decide to buy a smaller quantity at any price it would shift leftward.  “Change in Quantity Demanded” versus “Change in Demand” o The term quantity demanded means a particular amount that buyers would choose to buy at a specific price, represented by a single point on a demand curve. Demand, by contrast, means the entire relationship between price an quantity demanded, represented by the entire demand curve. o Change in quantity demanded: a movement along a demand curve in response to a change in price. o Change in demand: a shift of a demand curve in response to a change in some variable other than price. Factors that Shift the Demand Curve  Income- the amount that a person or firm earns over a particular period. o Normal good- a good that people demand more of as their income rises. o Inferior good- a good that people demand less of as their income rises. o A rise in income will increase the demand for a normal good, and decrease the demand for an inferior good.  Wealth- the total value of everything a person or firm owns, at a point in time, minus the total amount owed. o An increase in wealth will increase demand (shift the curve rightward) for a normal good, and decrease demand (shift the curve leftward) for an inferior good.  Prices of Related Goods o A substitute is a good that can be used in place of some other good and that fulfills more or less the same purpose. o When the price of a substitute rises it increases the demand for a good, shifting the demand curve to the right. o A complement is a good that is used together with some other good. o A rise in the price of a complement decreases the demand for a good, shifting the demand curve to the left.  Population o As the population increases in an area, the number of buyers will ordinarily increase as well, and the demand for a good will increase.  Expected Price o In many markets, an expectation that price will rise in the future shifts the current demand curve rightward, while an expectation that price will fall shifts the demand curve leftward.  Tastes o When tastes change towards a good, demand increases, and the demand curve shifts to the right. o When tastes change away from a good, demand decreases, and the demand curve shifts to the left.  Other Shift Variables: government subsidies, etc. Supply  Supply can change, and the amount of a good supplied in a market depends on the choices made by those who produce it.  We assume that those who supply goods and services have a goal: to earn the highest profit possible. However, they also face constraints.  First, in a competitive market, the price they can charge for their product is a given-the market price.  Second, firms have to pay the costs of producing and selling their product.  Quantity supplied- is the number of units of a good that all sellers in the market would choose to sell over some time period, given the constraints that they face.  Quantity Supplied Implies a Choice o It’s the quantity that firms choose to sell-the quantity that gives them the highest profit given the constraints they face.  Quantity Supplied Is Hypothetical o Quantity supplied makes no assumption’s about the firms’ ability to sell the good.  Quantity Supplied Depends on Price o The price of the good is just one variable among many that influences quantity supplied. The Law of Supply  Price and quantity supplied are positively related.  The Law of Supply states that when the price of a good rises, and everything else remains the same, the quantity of the good supplied will rise. The Supply Schedule and The Supply Curve  Supply Schedule- A list showing the quantities of a good or service that firms would choose to produce and sell at different prices, with all other variables held constant.  Supply Curve- shows the relationship between the price of a good and the quantity supplied in the market, holding constant the values of all other variables that affect supply. Each point on the curve shows the quantity that sellers would choose to sell at a specific price.  The supply curve is upward sloping. Shifts versus Movements Along the Supply Curve  A change in price causes a movement along the supply curve.  A change in any variable that affects supply-except for the good’s price- causes the supply curve to shift.  If sellers want to sell a greater quantity at any price, the supply curve shifts rightward.  If sellers would prefer to sell a smaller quantity at any price, the supply curve leftward.  Change in Quantity Supplied versus Change in Supply o Quantity supplied means a particular amount that sellers would choose to sell at a particular price, represented by a particular point on the supply curve. o The term supply, however, means the entire relationship between price and quantity supplied, as represented by the entire supply curve. o Change in quantity supplied: a movement along the supply curve in response to a price change. o Change in supply: a shift of a supply curve in response to a change in some other variable other than price. Factors That Shift the Supply Curve  Input prices- A fall in the price of an input causes an increase supply, shifting the supply curve to the right  Price of alternatives o Alternate goods- other goods that firms in a market could produce instead of the good in question. o Alternate market- a market other than the one being analyzed in which the same good could be sold. o When the price for an alternative rises-either an alternate good or the same good in an alternate market-the supply curve shifts leftward.  Technology- a technological advance in production occurs whenever a firm can produce a given level of output in a new and cheaper way than before. o Cost-saving technological advances increase the supply of a good, shifting the supply curve to the right.  Number of firms- an increase in the number of sellers-with no other changes-shifts the supply curve rightward.  Expected Price- In many markets, an expectation of a future price rise shifts the current supply leftward. Similarly, an expectation of a future price drop shifts the current supply curve rightward.  Changes in weather and other natural events- Favorable weather increases crop yields, and causes a rightward shift of the supply curve for that crop. Unfavorable weather destroys crops and shrinks yields, and shifts the supply curve leftward.  Other shift variables- ex. Taxes Putting Supply and Demand Together When a market is in equilibrium, both the price of the good and the quantity bought and sold have settled into a state of rest.  Equilibrium price- the market price that, once achieved, remains constant until either the demand curve or supply curve shifts.  Equilibrium quantity- the market quantity bought and sold per period that, once achieved, remains constant until either the demand curve or the supply curve shifts. Finding the Equilibrium Price and Quantity  Prices Below the Equilibrium Price o Excess demand- at a given price, the amount by which quantity demanded exceeds quantity supplied. o Prices would rise as buyers would offer to pay a higher price, rather than do without it. As prices rise buyers would demand a smaller quantity which is a leftward movement along the demand curve, as prices rise sellers increase supply which is a rightward movement along the supply curve. When the price reaches a equilibrium, excess demand is gone and prices stop rising.  Prices Above the Equilibrium Price o Excess supply- at a given price, the amount by which quantity supplied exceeds quantity demanded. o Sellers would compete with each other to sell more maple syrup than buyers wanted to buy and prices would fall. o The drop in price would be a leftward movement on the supply curve and a rightward movement on the demand curve. o These movements would continue until excess supply disappears.  Equilibrium On A Graph o To find the equilibrium in a competitive market, draw the supply and demand curves. Market equilibrium occurs where the two curves cross. At this crossing point, the equilibrium price is found on the vertical axis, and the equilibrium quantity on the horizontal axis. What Happens When Things Change  Example: Income Rises, Causing an Increase in Demand o A rightward shift in the demand curve causes a rightward movement along the supply curve. Equilibrium price and equilibrium quantity both rise.  Example: Bad Weather, Supply Decreases o A leftward shift of the supply curve causes a leftward movement along the demand curve. Equilibrium price rises, but equilibrium quantity decreases.  Example: Higher Income and Bad Weather Together o We can’t say what will happen to equilibrium quantity until we know which shift is greater and has the greater influence. Quantity can rise, fall, or remain the same. The Three-Step Process  Step 1: Characterize the Market o Decide which market or markets best suit the problem being analyzed, and identify the decision makers (buyers and sellers) who interact there.  Step 2: Find the Equilibrium o Describe the conditions necessary for equilibrium in the market, and a method for determining that equilibrium. o In this chapter we used supply and demand to find the equilibrium price and quantity in a perfectly competitive market.  Step 3: What Happens When Things Change o Explore how events or government policies change the market equilibrium. Using the Theory: The Oil Price Spike of 2007-2008  See book Chapter Four: Working with Supply and Demand Government Intervention in Markets  Fighting the Market: Price Ceilings o A price ceiling is a government imposed maximum price in a market. o When quantity supplied and quantity demanded differ, the short side of the market-whichever of the two quantities is smaller-will prevail. o Shortage- an excess demand not eliminated by a rise in price, so that quantity demanded continues to exceed quantity supplied. o A price ceiling creates a shortage and increases the time and trouble required to buy the good. While the price decreases, the opportunity cost may rise. o The government may not be able to prevent a black market, where goods are sold illegally at prices higher than the legal ceiling.  The black market price will typically exceed the original, freely determined equilibrium price. o the unintended consequences of price ceilings-long lines, black markets, and, often higher prices-explain why they are generally a poor way to bring down prices. o Permanent or semi permanent price ceilings are exceedingly rare. o An Example: Rent Controls  Rent controls- Government-imposed maximum rents on apartments and homes.  Most states have laws prohibiting rent control but more than a dozen states allow it including (NY, CA, MD and NJ).  Rent controls often do not go to those who they are targeting, they create persistent excess demand which leads to buyers facing more time and trouble to find an apartment and they often end up paying market price or higher. Also rent controls cause a decrease in the quantity of apartments supplied which could and often times does lead to higher rents.  Fighting the Market: Price Floors o Sometimes governments try to help sellers of a good by establishing a price floor-a minimum amount below which the price is not permitted to fall. o Most common use of price floors in the world has been to raise or prevent prices from falling in agricultural markets. o Price floors for agricultural goods are commonly called price support programs. o In the United States price support programs began during the Great Depression after farm prices fell by more than 50% between 1929 and 1932. o The Agricultural Adjustment Act of 1933, and an amendment in 1935, gave the president the authority to intervene in markets for a variety of agricultural goods. o The price floor prevents the excess supply from pushing the market price back down to its equilibrium value, which results in a surplus. o Surplus- an excess supply not eliminated by a fall in price, so that quantity supplied continues to exceed quantity supplied. o Maintaining a Price Floor  The government promises to buy any unsold product at a guaranteed price, this reduces the temptation for farmers to illegally sell their product at a lower price to sell all of their supply.  A price floor creates a surplus of a good. In order to maintain the price floor the government must prevent the surplus from driving down the market price. In practice, the government often accomplishes this goal by purchasing the surplus itself.  Price floors are usually accompanied by government efforts to limit any excess supplies.  Price floors often get the government deeply involved in production decisions, rather than leaving them to the market.  Manipulating the Market: Taxes o A tax on a specific good or service is an excise tax. o An Excise Tax on Sellers  A tax collected from sellers shifts the supply curve upward by the amount of the tax.  Tax infidence- the division of a tax payment between buyers and sellers, determined by comparing the new (after tax) and old (pretax) market equilibriums.  The incidence of a tax that is collected from sellers o An Excise Tax on Buyers  A tax collected from buyers shifts the demand curve downward by the amount of the tax.  The incidence of a tax that is collected from buyers falls on both sides of the market. Buyers pay more, and sellers receive less, for each unit sold. o Tax Incidence Versus Tax Collection  The numerical incidence of any tax will depend on the shapes of the supply and demand curve.  The incidence of the tax (the distribution of the burden between buyers and sellers) is the same whether the tax is collected from buyers or sellers.  Manipulating the Market: Subsidies o A subsidy is the opposite of a tax. o Subsidy- a government payment to buyers or sellers on each unit purchased or sold. A subsidy lowers prices to buyers and encourages people to buy it. o A Subsidy to Buyers  A subsidy paid to buyers shifts the demand curve upward by the amount of the subsidy.  A subsidy paid to buyers benefits both sides of a market. Buyers pay less and sellers receive more for each unit sold.  Look in book for education example! o A Subsidy to Sellers  The distribution of benefits from a subsidy is the same, regardless of whether the subsidy is paid to buyers or sellers. Supply and Demand in Housing Markets A requirement for analyzing a market is that there are many buyers and sellers, and each regards the market price as given.  What’s Different About Housing Markets? o Most of the homes that people own, and most that changes hands each year, were originally built and sold lone before.  A Detour: Stock and Flow Variables  A stock variable measures a quantity in existence at a moment in time. (15 gallons in tub)  A flow variable measures a process that takes place over a period of time. (2 gallons per minute)  Number of homes that people own at a given time is referred to as the housing stock.  New home construction and new home purchases are flow variables: so many homes are built or purchased per month or per year.  It is best to think of the supply and demand for homes in terms of the housing stock.  When looking at it this way, the equilibrium occurs when the total number of homes people want to own is equal to the total number available for ownership (the housing stock).  Supply and Demand Curves in a Housing Market o The supply curve for the housing stock is vertical because it’s fixed. o The demand curve tells us the number of families who want to be homeowners at each price.  Behind the Demand Curve: Ownership Costs o Anyone deciding whether to be a homeowner will compare the cost of ownership with the next best thing: renting. o Home Prices and Monthly Costs for Prospective Owners  The greater the purchasing price, the greater the monthly interest forgone because it is used towards the house rather than being in an account where interest could be earned.  Many times homeowners get a mortgage, a loan given to homeowners for part of the purchase price of the home.  For a prospective homeowner, the monthly cost of owning a home will vary directly with the price of the home. o Home Prices and Monthly Costs for Current Owners  Any change in the home’s cost –even after it was purchased- will change the owner’s monthly costs.  Continued ownership means continued forgone interest.  Both current and prospective homeowners face a monthly cost of ownership. This monthly cost rises when home prices rise and fall when home prices fall.  When housing prices fall and nothing else changes, the monthly cost of owning a home declines as well. With lower monthly costs, more people will prefer to own rather than rent, so the quantity of homes demanded increases. o Shifts versus Movement Along the Demand Curve  A movement occurs when price of a home changes whereas a shift occurs if any other factor besides price changes. Housing Market Equilibrium  The equilibrium price in a housing market is the price at which the quantity of homes demanded (the number of people who want to own) and quantity supplied (the housing stock) are equal. What Happens When Things Change  Over time both the supply and demand curves will shift rightward. The supply curve shifts rightward as the housing stock rises (new homes are built). The demand curve shifts rightward for a variety of reasons including population growth and rising incomes.  The market equilibrium will move rightward over time as well, but what happens to home prices depends on the relative shifts in the supply and demand curves.  Equal Changes in Supply and Demand: A Stable Housing Market o When the housing stock grows at the same rate as housing demand, house prices remain unchanged. o This is not entirely realistic because in housing markets, construction costs for labor and raw materials tend to rise over time. In order to cover these rising costs and continue increasing the housing stock, average home prices must rise over time, at least moderately.  Restrictions on New Building: Rapidly Rising Prices o When restrictions on new building prevent the housing stock from growing as fast as demand, housing prices rise. Can explain why housing prices have increased so rapidly in cities in NY and CA.  Faster Demand Growth: Rapidly Rising Prices o A house can also be an asset. o Capital gain: the gain to the owner of an asset when it is sold for a price higher than its price when originally purchased. o Capital loss: The loss to the owner of an asset when it is sold for a price lower than its price when originally purchased. o Anticipated capital gains are one of the reasons that most people hold assets, including homes. o A home is one of the most leveraged financial investments that people can ever make. o Leverage magnifies the impact of a price change on the rate of return you will get from an asset. o When home prices, your rate of return from investing in a home can be several times the percentage growth in housing prices. o This makes the demand for housing particularly sensitive to changing expectations about future home prices. o It takes time for the housing stock to catch up to the change in demand because the year’s housing stock is based on construction started in the previous year and it takes time. When housing prices rise there is more incentive to build but it takes time to catch up. o When the demand for housing begins rising faster than previously, the housing stock typically lags behind, and housing prices rise. Using the Theory: The Housing Boom and Bust of 1997-2008  See Book Chapter Five: Elasticity Elasticities are measures of the sensitivity of one variable to another. Price Elasticity of Demand  Price elasticity of demand measures the sensitivity of quantity demanded to the price of the good itself.  Problems with Slope The slope of a demand curve depends on arbitrary units of measurement that we happen to choose. Also, the slope of the demand curve doesn’t tell us anything about the significance of a change in price or quantity-whether it is relatively small or a relatively large change. The Elasticity Approach o The elasticity approach solves both of these problems by comparing the percentage change in quantity demanded with the percentage change in price. o The price elasticity of demand for a good is the percentage change in quantity demanded divided by the percentage change in price. It is the sensitivity of quantity demanded to price; the percentage change in quantity demanded caused by a 1 percent change in price.  in this book we’ll look at elasticity in absolute terms.  The greater the elasticity value, the more sensitive quantity demanded is to price.  Calculating Price Elasticity of Demand o When calculating the price elasticity of demand we imagine that only price is changing, while we hold constant all other influences on quantity demanded, such as buyers’ incomes, the prices of other goods and so on. Essentially, we measure elasticity for a movement along an unchanging demand curve. o Elasticity value will also depend on the direction moved (upward or downward). o When determining elasticities o We calculate the percentage change in a variable using the midpoint formula: the change in the variable divided by the average of the old and new values. o Look art book for % change in price and % change in quantity demanded formulas. o We use the midpoint formula only when calculating elasticity values from data on prices and quantities. For all other purposes, we calculate percentage change in the normal way, using the starting value as the base.  Categorizing Demand o Perfectly Inelastic Demand- a price elasticity of demand equal to 0.  A perfectly inelastic demand curve is vertical, so a change in price causes no change in quantity demanded. o Inelastic Demand- a price elasticity of demand between 0 and 1. (quantity changes by a smaller % than price). o Elastic Demand- A price elasticity of demand greater than 1 (quantity changes by a larger percentage than price changes). o Perfectly (infinitely) Elastic Demand- a price elasticity of demand approaching infinity  As long as the price stays at one particular value, any quantity might be demanded. But even the tiniest price rise would cause quantity demanded to fall to 0. o Unit Elastic Demand-a price elasticity of demand equal to 1.  Elasticity and Straight-Line Demand Curves o Elasticity is the ratio of percentage changes; what remains constant along a linear demand curve is the ratio of absolute or unit changes. o Elasticity of demand varies along a straight-line demand curve. More specifically, demand becomes less elastic (Elasticity of demand gets smaller as we move downward and rightward.  Elasticity and Total Revenue o TR (Total Revenue) = P (Price per Unit) x Q (Quantity that people buy) o At any point on a demand curve, sellers’ total revenue is the area of a rectangle with a height equal to price and width equal to quantity demanded. o An increase in price raises total revenue when demand is inelastic, and shrinks total revenue when demand is elastic. o A decrease in price shrinks total revenue when demand is inelastic, and raises total revenue when demand is elastic. o If demand is unit elastic a 1 percent change in price would cause a 1 percent change in quantity and they would cancel each other out.  Determinants of Elasticity o Availability of Substitutes  When close substitutes are available for a good, demand will be more elastic.  One factor that determines the closeness of substitutes is how narrowly or how broadly we define the market. Ex. Demand in the market for soft drinks will be less elastic than demand in the market for Coke.  This is because when determining the elasticity of demand in a market, we hold constant all prices outside of the market. o Necessities vs. Luxuries  When we regard something as “necessity,” demand for it will tend to be less elastic.  Goods we regard as necessities tend to have less elastic demand than goods we regard as luxuries.  Still with this the narrowness or broadness in the definition of the market is important. Ex. Clothes would be inelastic while designer jeans would be more elastic. o Importance in Buyers’ Budget  When spending on a good makes up a large proportion of families’ budgets, demand tends to be more elastic. o Time Horizon  Short-run elasticity: An elasticity measured just a short time after a price change.  Long-run elasticity: An elasticity measured a year or more after a price change.  The longer we wait after a price change to measure the quantity response, the more elastic is demand. Therefore, long run elasticities tend to be larger than short-run elasticities.  Time Horizons and Demand Curves o Price elasticity of demand is measured along a demand curve. o There can be more than one demand curve associated with a specific market.  whenever we draw a demand curve we do it for a specific time horizon. o Any demand curve is for a particular time horizon (a waiting period before we observe the new quantity demanded after a price change). In general, the longer the time horizon, the more elastic the demand.  Two Practical Examples o Elasticity and Mass Transit  Several studies have shown that the demand for mass transit is inelastic. This means that a rise in fares would likely raise mass-transit revenue for a city, even in the long run.  Elasticity estimates come from past data on the response to price changes. When we ask what would happen if we raise the price, we are extrapolating from these past responses. For small price changes the extrapolation would be fairly accurate. But large price changes move us into unknown territory and elasticity may change. Demand could be elasticity for a very large price hike, and then total revenue would fall. This puts a limit on fares, even if a city’s goal is the maximum possible revenue.  Also generating revenue is only one consideration in setting mass transit fares. City governments are also concerned with providing affordable transportation to city residents, reducing traffic congestion on city streets and limiting pollution. A fare increase, even if it would raise total revenue, would work against these other goals. This is why most cities keep the price of mass-transit below the revenue-maximizing price. o Elasticity and Oil Prices  The inverse of elasticity tells us the percentage rise in price that would bring about each 1 percent decrease in quantity demanded.  See book for more Other Elasticities  Elasticity can be used to measure the sensitivity of virtually any variable to any other variable.  All types of elasticity measures tell us the percentage change in one variable caused by a 1 percent change in the other.  Income Elasticity of Demand o The income elasticity of demand tells us how sensitive quantity demanded is to changes in buyers’ incomes. o Income elasticity of demand- The % change in quantity demanded caused by a 1% change in income. All other influences on demand are remaining constant. o Income elasticity = (% change in QD) / (% change in income) o While price elasticity measures the sensitivity of demand to prices as we move along the demand curve from one point to another, an income elasticity tells us the relative shift in the demand curve-the percentage increase in quantity demanded at a given price. o With income elasticities (unlike other elasticities) the sign of the elasticity value matters. o Income elasticity will be positive when people want more of a good as their income rises, such goods are called normal goods. o Income elasticity can also be negative, when a rise in income decreases demand for a good (inferior goods). o Income elasticity is positive for normal goods and negative for inferior goods.  Cross-Price Elasticity of Demand o A cross-price elasticity relates the percentage change in quantity demanded for one good to the percentage change in the price of another good. o Cross-price elasticity of demand is the percentage change in the quantity demanded of one good caused by a 1 percent change in the price of another good. o We define the cross-price elasticity between good X and good Z as:  (% change in QD of X) / (% change in price of Z) o With a cross-price elasticity (as with income elasticity), the sign matters.  A positive cross-price elasticity means that the two goods are substitutes. A rise in the price of one good increases the demand for the other good.  A negative cross-price elasticity means that the goods are complements. A rise in the price of one good decreases the demand for the other good.  Price Elasticity of Supply o It is the percentage change in the quantity supplied of a good or service that is caused by a 1 percent change in the price of the good, with all other influences on supply held constant. o Price Elasticity of Supply = (% change in QS) / (% change in price) o The price elasticity of supply measures the sensitivity of quantity supplied to price changes as we move along the supply curve. o A large value for the price elasticity of supply means that quantity supplied is very sensitive to price changes. o A major determinant of supply elasticity is the ease at which suppliers can find profitable activities that are alternatives to producing the good in question.  Supply will tend to be more elastic when suppliers can switch to producing alternate goods more easily.  The nature of the good plays a role in the ability to switch production to alternative goods.  The narrowness of the market definition matters too- especially geographic narrowness. Ex. The market for oranges in Illinois would be more supply-elastic than the market for oranges in the United States. In the Illinois market, a decrease in price implies that we are holding constant the price of oranges in all other states. This gives suppliers and easy alternative, they could sell their oranges in other states.  The time horizon is also important. The longer we wait after a price change, the greater the supply response to a price change.  Supply for many products becomes more elastic the longer we allow sellers to respond to a price change. In general, long-run supply elasticities are greater than short-run supply elasticities. Using the Theory See Book Chapter Six: Consumer Choice The Budget Constraint  Two facts of economic life: (1) We have to pay for the goods and services we buy, and (2) we have limited funds to spend  A consumer’s budget constraint identifies which combination of goods and services the consumer can afford with a limited budget, at given prices.  Budget line- The graphical representation of a budget constraint, showing the maximum affordable quantity of one good for given amounts of another good. o Any point below or to the left of the budget line is affordable. o The budget line serves as a border between those combinations that are affordable and those that are not. o Relative Price- The price of one good relative to the price of another (one money price divided by another money price). o The relative price of a concert, the opportunity cost of another concert, and the slope of the budget line have the same absolute value. o The slope of the budget line indicates the spending tradeoff between one good and another-the amount of one good that must be sacrificed in order to buy more of another good. If P sub-y is the price of the good on the vertical axis and P sub-x is the price of the good on the horizontal axis, then the slope of the budget line is –Psub-x/Psub-y  Changes in the Budget Line o The “givens”-the prices of the goods and the consumer’s income- are always assumed constant as we move along a budget line; if any one of them changes; the budget line will change as well. o Changes in Income  An increase in income will shift the budget line upward (and rightward). A decrease in income will shift the budget line downward (and leftward). These shifts are parallel: changes in income do not affect the budget line’s slope. o Changes in Price  When the price of a good changes, the budget line rotates: Both its slope and one of its intercepts will change. Preferences  Rationality o One common denominator-and critical assumption behind consumer theory-is that people have preferences. o Another common denominator is that preferences are logically consistent, or transitive. o When a consumer can make choices, and is logically consistent, we say that she has rational preferences. o Rational preferences are preferences that satisfy two conditions: (1) Any two alternatives can be compared, and one is preferred or else the two are valued equally, and (2) the comparisons are logically consistent or transitive. o Rationality is a matter of how you make your choices, and not what choices you make.  More is Better o Another feature of preferences that virtually all of us share is this: We generally feel that more is better. Specifically, if we get more of one good or service, and nothing else is taken away from us, we will generally feel better off. o The consumer will always choose a point on the budget line, rather than a point below it. o We can always find at least one point on the budget line that is preferred, as long as more is better. o There are two theories of consumer decision making that share much in common. First, both assume that preferences are rational and secondly, both assume that the consumer would be better off with more of any good we’re considering. o This means that the consumer will always choose a combination of goods in, rather than below, his budget line. Both theories come to the same general conclusion about consumer behavior. However, to arrive at those conclusions, each theory takes a different road. o Both approaches to consumer theory are models. Households or consumers don’t actually use these techniques but rather our assumption is that people mostly behave as if they use them. Consumer Decisions: The Marginal Utility Approach  Economists assume that any decision-maker tries to make the best out of any situation. Marginal utility theory treats consumers as striving to maximize their utility- an actual quantitative measure of well-being or satisfaction.  Utility and Marginal Utility o Although Lisa’s utility increases every time she consumes more ice cream, the additional utility she derives from each successive cone gets smaller and smaller as she gets more cones. o Marginal utility is the change in utility an individual enjoys from consuming an additional unit of a good. o Law of diminishing marginal utility- as consumption of a good or service increases, marginal utility decreases. o Because marginal utility is the change in utility caused by a change in consumption from one level to another, we plot each marginal utility entry between the old and new consumption levels. o Diminishing marginal utility is seen by the downward sloping marginal utility curve, and the positive but decreasing slope (flattening out) of the total utility curve. o When we use marginal utility theory, we assume that marginal utility for every good is positive based on the assumption we make that people always prefer more rather than less of any good.  Combining the Budget Constraint and Preferences o The marginal utility someone gets from consuming more of a good tells us about his preferences. By contrast, his budget constraint tells us only which combination of goods he can afford. o Marginal utility per dollar spent on concerts is found by dividing the marginal utility of the last concert by the price of a concert. This tells us the gain in utility Max gets for each dollar he spends on the last concert. o Marginal utility per dollar, like marginal utility itself, declines as Max attends more concerts. o Highest possible utility is found where the marginal utility per dollar is the same for both goods. o For any two goods x and y, with prices Px and Py, whenever MUx/Px > MUy/Py, a consumer is made better off shifting spending away from y and toward x. When MUy/Py > MUx/Px, a consumer is made better off shifting spending away from x and toward y. o A utility-maximizing consumer will choose the point on the budget line where marginal utility per dollar is the same for both goods (MUx/Px = MUy/Py). At that point, there is no further gain from reallocating expenditures in either direction. o Regardless of the amount of goods to choose from, when the consumer is doing as well as possible, it must be true that Mux/Px = MUy/Py for any pair of goods, x and y. If this condition is not satisfied, the consumer will be better off consuming more one and less of the other good in the pair.  What Happens When Things Change o Changes in Income  A rise in income-with no change in prices-leads to a new quantity demanded for each good. Whether a particular good is normal (QD increases) or inferior (QD decreases) depends on the individual’s preferences, as represented by the marginal utilities for each good, at each point along his budget line. o Changes in Price  Change in price rotates the budget line; a drop in price rotates it rightward and an increase in price rotates it leftward. o The Consumer’s Demand Curve  See textbook Income and Substitution Effects  The Substitution Effect o The substitution effect of a price change arises from a change in the relative price of a good, and it always moves quantity demanded in the opposite direction to the price change. When price decreases, the substitution effect works to increase quantity demanded; when price increases, the substitution effect works to decrease quantity demanded. o The impact of a price decrease is called a substitution effect: the consumer substitutes toward the good whose price has decreased, and away from other goods whose prices have remained unchanged. o The substitution effect is the main factor responsible for the law of demand.  The Income Effect o The income effect of a price change arises from a change in purchasing power over both goods. A drop in price increases purchasing power, while a rise in price decreases purchasing power. o The income effect of a price cut can work to either increase or decrease the quantity of a good demanded, depending on whether the good is normal or inferior.  Combining Substitution and Income Effects o A change in the price of a good changes both the relative price of the good (the substitution effect) and the overall purchasing power of the consumer (the income effect). The ultimate impact of the price change will depend on both of these effects o For normal goods, these two effects work together to push quantity demanded in the same direction. For inferior goods, the two effects oppose each other. o Normal Goods  For normal goods, the substitution and income effects work together, causing quantity demanded to move in the opposite direction of the price. Normal goods, therefore, must always obey the law of demand. o Inferior Goods  In practice, the substitution effect virtually always dominates for inferior goods.  For inferior goods, the substitution and income effects of a price change work against each other. The substitution effect moves quantity demanded in the opposite direction of the price, while the income effect moves it in the same direction as the price. But since the substitution effect virtually always dominates, consumption of inferior goods-like normal goods- will virtually always obey the law of demand. Consumers in Markets  The market demand curve is found by horizontally summing the individual demand curves of every consumer in the market.  As long as each individual’s demand curve is downward sloping (and this is virtually always the case), then the market demand curve will also be downward sloping.  If a rise in price makes each consumer buy fewer units, then it will reduce the quantity bought by all consumers as well.  Indeed, the market demand curve can still obey the law of demand even when some individuals violate it. Consumer Theory in Perspective  Extensions of the Model o One extension of the model is to incorporate choices among many goods rather than just two. o Another extension is to recognize saving and borrowing. A way to incorporate these possibilities is to define one of the goods as “future consumption.” In that case, saving means sacrificing consumption of all goods now in order to have more future consumption, and borrowing means the opposite. o More difficult extensions incorporate uncertainty and imperfect information. o Consumer theory always regards people relentlessly selfish, concerned only about their own consumption. When people trade in impersonal markets, this is mostly true: People do generally try to allocate their spending among different goods to achieve the greatest personal satisfaction. o However, in many areas of economic life, people act unselfishly. This, too, can be incorporated into the traditional model of consumer theory. One way is to treat the “satisfaction of others” (say, a family member or society at large) as another “good.”  Behavioral Economics o Behavioral economics has shown that preferences are sometimes irrational, and people sometimes make decisions-even highly consequential decisions-against their own interests, often in predictable ways. It is a subfield of economics focusing on decision- making patterns that deviate from those predicted by traditional consumer theory. o Salience  Consumers often make decisions based not just on the outcome, but on the salience of a particular outcome-the extent to which it “jumps out at them.”  Salience also plays a role in major economic decisions, such as taking out mortgage loans, borrowing on credit cards, or buying insurance.  Corporations exploit salience by arranging documents or keep certain facts from standing out. o Preference for Defaults  If choices are based on rational preferences, the “default choice” should not matter.  Studies have shown that people tend to stick to the default choice for some decisions.  Ex. Companies having “opt in for email” selected when people sign up for accounts and making them uncheck it to not get the emails. o Decision-Making Environment  Sometimes, the environment in which a decision is made can exert a strong and surprising influence.  This violates traditional consumer theory, where preferences are assumed to be based on a comparison of alternatives, and not on how or where the alternatives are presented.  Retailers know that the environmental context matters, and try to influence purchasing decisions by controlling the music in the store, the scent in the air, or even the thickness beneath customers’ feet. o Self-Binding  A decision-maker should always prefer a wide array of choices to a narrow one.  However, in daily life we see decision-makers contradict this principle just as Ulysses did. They would prefer to bind themselves to a narrow set of choices, for their own long-run good. o Behavioral Economics and Policy  See book o Behavioral Economics and Traditional Theory  Traditional economic theory assumes that consumers have rational preferences.  Behavioral economics analyzes decisions that violate rational preferences.  The best model to use depends on the issue we are analyzing.  In most markets, most of the time, consumer responses can be understood very well with the traditional model.  Gas tax affect on demand for cars (traditional) vs. why consumers buy certain cars that trap them into buying more gas (non-traditional)  Few economists see behavioral economics as an alternative to traditional economics, rather they see it as an addition. Using the Theory: Improving Education See book Appendix: The Indifference Curve Approach  An Indifference Curve o An indifference curve represents all combinations of two goods that make the consumer equally well off. o The Marginal Rate of Substitution (MRS)  The marginal rate of substitution of good y for good x along any segment of an indifference curve is the maximum rate at which a consumer would willingly trade units of y for units of x. o MRS at a point  MRS depends on the size of the segment we are considering.  The MRS at any point on the indifference curve is equal to (the absolute value of) the slope of the curve at that point. When measured at a point, the marginal rate of substitution of good y for good x tells us the maximum rate at which a consumer would willingly trade good y for a tiny bit more of good x. o How MRS Changes Along an Indifference Curve  As we move down an indifference curve, the MRS gets smaller and smaller. This is because initially he, for example would see a lot of movies and not a lot of concerts, he would value another concert more highly but as he sees more and more concerts he will not value them as much as he did before.  The Indifference Map o An indifference map is a set of indifference curves that describe Max’s preferences, like the curves in figure A.2. o Any point on a higher indifference curve is preferred to any point on a lower one. o An indifference map gives us a complete characterization of someone’s preferences: It allows us to look at any two points and- just by seeing which indifference curves they are on-immediately know which, if either, is preferred.  Consumer Decision Making o An optimal combination of goods for an individual to make them as well off as possible will (1) be a point on his budget line, and (2) it will lie on the highest indifference curve possible. o When an indifference curve actually crosses the budget line, we can always find some other point on the budget line that lies on a higher indifference curve. o The absolute value of the indifference curve’s slope-the MRS-tells us the rate at which Max would willingly trade movies for concerts. o The slope of the budget line, by contrast, tells us the rate at which Max is actually able to trade movies for concerts. o If there’s any difference between the rate at which Max is willing to trade one good for another and the rate at which he is able to trade, he can always make himself better off by moving to another point on the budget line. o The optimal combination of goods for a consumer is the point on the budget line where an indifference curve is tangent to the budget line. o The optimal combination of two goods x and y is that combination on the budget line for which MRS (goods y and x) = Px/Py.  What Happens When Things Change? o Changes in Income  A rise in income, with no change in prices, leads to a new quantity demanded for each good. Whether a particular good is normal (QD increases) or inferior (QD decreases) depends on the individual’s preferences, as represented by his indifference map. o Changes in Price  Rotate the budget line (drop in prices rotates it rightward)  The Individual’s Demand Curve o See book Chapter Seven: Production and Cost A firm’s managers strive to earn the highest possible profit, the difference between a firm’s revenues and its costs. Controlling costs is one way to increase profits. Production  Business firm- An organization, owned and operated by private individuals, that specializes in production.  Production is the process of combining inputs to make goods and services.  Production creates both goods and services.  The inputs used in production include the four resources (land, labor, capital, and entrepreneurship) plus other goods, like paper, ink and transportation.  Technology and Production o Technology- the methods available for combining inputs to produce a good or service. o If the firm’s technology allows it to use different methods for producing the same level of output, we assume the firm will use the cheapest method it can find. o In this chapter we’ll spell out the production technology for a mythical firm that uses only two inputs: capital and labor.  Short-Run versus Long-Run Decisions o When a firm changes its level of production, it will want to adjust the amount of inputs it uses. These adjustments depend on the time horizon the firm’s managers are thinking about. Some inputs can be adjusted relatively quickly while others may take longer to adjust. o Time horizons firms can use can be split up into two broad categories: long-run and short-run  The long-run is a time period long enough for a firm to change the quantity of all its inputs.  Over the long-run, all the inputs the firm uses are viewed as variable inputs, an input whose usage can change as the level of output changes.  In shorter time periods the company may be stuck with the current quantities of some inputs. Fixed inputs are inputs, that the time period we’re considering, cannot be adjusted as output changes.  The short-run is a time period during which at least one of the firm’s inputs is fixed. Production in the Short-Run  When firms make decisions in the short-run, there is nothing they can do about their fixed inputs: they are stuck with whatever quantity they have. However, they can make choices about their variable inputs.  Total Product (Q)- the maximum quantity of output that can be produced from given combination of inputs. o In the table, the total product numbers tell us the maximum output for each numbers of workers. o For each value of the total product, the labor column shows us the lowest number of workers that can produce it. Because labor is the only variable input, this lowest number of workers will also be the least-cost method of producing any level of output. o The total product curve shows the total amount of output that can be produced using various numbers of workers. The marginal product of labor (MPL) is the change in total product when another worker is hired. o The marginal product of labor (MPL) is the change in the total product (^Q) divided by the change in the number of workers employed (^L): MPL = Change in total product (^Q) / Change in the number workers employed (^L)  Marginal Returns to Labor o As more and more workers are hired, the MPL first increases (the vertical arrow grows longer) and then decreases (the arrows get shorter). o Increasing Marginal Returns to Labor  When the marginal product of labor increases as more workers are hired, there are increasing marginal returns to labor.  This may happen because more workers may allow production to become more specialized. o Diminishing Marginal Returns to Labor  When the marginal product of labor is decreasing, we say that there are diminishing marginal returns to labor.  Output still rises when another worker is added, so marginal product is positive. But the rise in output is smaller and smaller with each successive worker.  This occurs because as workers keep being added additional gains from specialization will be harder to achieve and each worker will have less and less of the fixed inputs with which to work.  The last point applies to all kinds of production: as we keep increasing the quantity of any one input, while holding the others fixed, diminishing marginal returns will eventually set in.  The law of diminishing (marginal) returns states that as we continue to add more of any one input (holding the other inputs constant), its marginal product will eventually decline.  The law of diminishing returns is a physical one and not an economic one. It is based on the nature of production-on the physical relationship between inputs and outputs with a given technology. Thinking About Costs  Production is the physical relationship between inputs and outputs.  A firm’s total cost of producing a given level of output is the opportunity cost of the owners-everything they must give up in order to produce that amount of output.  The Irrelevance of Sunk Costs o A sunk cost is one that has already been paid, or must be paid, regardless of any future action being considered. o Sunk costs should not be considered when making decisions. o In the textbook example, what should be considered are the costs that do depend on the decision about producing the drug, namely, the cost of actually manufacturing it and marketing it for the smaller market. If the costs are less than the earnings in annual revenue then ACME should do it. o Even a future payment can be sunk, if an unavoidable commitment to pay it has already been made.  Explicit versus Implicit Costs o Explicit costs involve actual payment while implicit costs involve no money changing hands. o Using a building you already owned for a restaurant may be free in the eyes of an accountant but to an economist it is not because you could be renting it out to someone else.  The foregone rent is an implicit cost, and it is as much a cost of production as the rent you would pay if you didn’t own a building yourself. o Foregone interest is another implicit cost of the business because the money used to start it could be in the bank or lent to someone else. o Becoming manager of the business doesn’t escape the costs of hiring one because you could do something else with your time and the foregone labor income is yet another implicit cost of your business and is therefore part of the opportunity cost. Cost in the Short Run  No matter how much output is produced, the quantity of a fixed input must remain the same. Other inputs, by contrast, can be varied as output changes.  Because a firm has these two different types of inputs in the short run, it will also face two different types of costs.  The cost of a firm’s fixed inputs are called fixed costs. o Fixed costs remain the same regardless of the level of output. o We regard rent and interest-whether explicit or implicit-as fixed costs, since producing more or less output in the short run will not cause these costs to change. o Managers typically refer to fixed costs as overhead costs or just overhead.  The cost of obtaining the firm’s variable inputs are its variable costs. o These costs will rise as output increases along with the variable inputs themselves. o Most businesses treat the wages of hourly employees and the costs of raw materials as variable costs, because quantities of labor and raw materials
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